In this article, we will be discussing the differences between operating expenses and capital expenditures in order to help small business owners and bookkeepers with their accounting goals. We also will spend some time discussing the various tax implications of the various types of capital expenditures and will touch on some standard tax analysis techniques to help small businesses succeed in their financial goals.
What are operating expenses?
A standard definition of operating expenses, as described by the Corporate Finance Institute, is as follows: "the costs incurred by a business for its operational activities. In other words, operating expenses are the costs that a company must make to perform its operational activities."
Examples of operating expenses
Expense items such as utilities, accounting fees, marketing fees, rent, and payroll are considered to be operating expenses. Cost of Goods Sold (COGS) or Cost of Sales are also a type of operating expense but are usually classified in a different section of the income statement.
What are capital expenditures?
Investopedia aptly provides the IRS's definition of capital expenditures as the following: " the purchase of assets whose usefulness or value to a company exceeds one year." Many things will qualify as capital expenditures but often includes assets such as buildings, vehicles, building improvements, and equipment.
What are the different types of IRS deductions for capital expenditures?
- Section 179 Tax Deduction - The IRS allows businesses to deduct 100% of the equipment, vehicles, computer software, and office furniture that is purchased or leased in the same tax year, up to an annual limitation on the deduction itself and the total equipment purchased amount for the year ($1,080,000 and $2,700,000, respectively,) for 2022.
- Bonus Depreciation - Not subject to the limits or rules of the Section 179 Tax Deduction, businesses can deduct larger amounts of depreciation for most non-real estate capital expenditures in the first year the asset is placed in service.
- IRS MACRS Depreciation - The IRS uses depreciation tables to classify different types of property and when and how they can be depreciated.
Basis strategies to use in tax analysis
Most new businesses and growing businesses are usually in a position where their main tax objective is to reduce the amount of money they owe the IRS in the current tax year in order to maximize the amount of cash they have available to reinvest into their business. Under this consideration, these businesses should absolutely be looking to maximize their tax deduction for all assets acquired. This usually involves the Section 179 Tax Deduction for all capital expenditures acquired during the tax year.
Another common strategy involved with tax planning for businesses is an analysis that estimates the total tax effect of a capital expenditure by using the current effective tax rate or the business or business owner(s) and by estimating the future effective tax rates of the business or business owner(s). The crux of this analysis centers around the fact that more tax savings can be had when the capital expenditure is deducted in years where there is higher business income and/or taxable income.
Whatever strategy is used, there are some complexities and cash flow management planning that needs to be considered closely in order to maximize these benefits to businesses. By working closely on every detail, the professionals at Cloonan & Associates, PC can assist business owners and managers at maximizing these deductions for their companies.